Dividend safety in stocks isn’t

Sunday

Dec 2, 2012 at 12:01 AM

Timing matters. All too often investors succumb to the temptation to buy a stock that's been a hot performer, only to get in when it's about to go cold.

One market strategist says such a turning point is approaching fast for many dividend-paying stocks. They've been popular because dividend payers are frequently touted as a relatively low-risk investment option.

"People who have been seeking safety will discover they really didn't get what they thought they were buying," says Seth Masters, chief investment officer with mutual fund company and asset manager AllianceBernstein.

It's easy to understand the appeal of dividend stocks, often favored by retirees and other investors seeking to generate income from their portfolios. With inflation now at about 2.2 percent, dividends offer greater potential than many bond investments to keep pace with rising prices. For example, 10-year Treasurys now yield around 1.6 percent. That's substantially less than the average 2.7 percent yield of dividend-paying stocks in the Standard & Poor's 500 index.

Dividend-payers typically have more cash on hand and steadier income than growth-oriented companies. So dividend stocks tend to fall less sharply when the market declines.

That safety message is getting through. Mutual funds specializing in dividend-paying stocks have attracted more than $60 billion over the last three years. That number wouldn't normally be impressive, except that cash has flowed in as investors pulled out of nearly all other types of stock funds.

Even so, Masters says it's time to take a critical look at dividends. At a recent presentation in Boston, he told AllianceBernstein clients that buying these stocks at current prices could be much riskier than expected.

The concern is that the stocks paying the highest yields have appreciated more rapidly than most other stocks since the market hit bottom in 2009.

Masters cites data showing that these high-yielding stocks have gained so much that they've recently traded at a 50 percent premium to their historical average. That premium is calculated based on the average price-earnings ratio since 1951 for the 20 percent of stocks with the highest dividend yields. The P/E ratio divides a company's stock price by the company's annual earnings per share. A higher ratio suggests a stock is expensive because, in a sense, it takes more years of earnings for investors to get back they paid for it. A lower ratio suggests it is cheap.

Masters believes it's only a matter of time before prices of those top dividend-payers get back in sync with the historic average. That means these stocks would eventually underperform other segments of the market.

Due to the strong gains for such top dividend-payers, these stocks make up a greater share of the S&P 500 index than they did a few years ago. The highest-yielding dividend payers account for about 44 percent of the market cap of stocks in the S&P 500, up from an average 34 percent dating to 1970, Masters says.

These stocks have gotten "extremely expensive," he says.

Dividend stocks could also become less attractive from a tax standpoint, especially for investors in the top income bracket. Dividend income has been taxed at a maximum 15 percent since 2003. But that rate will expire in January unless Congress and President Barack Obama reach a compromise first on taxes and government spending. Dividends would be taxed as ordinary income in 2013, and rates would go up depending on which income bracket a taxpayer is in. For the highest earners, the dividend rate would jump to 43.4 percent.

By expressing concern over the current prices of the market's top dividend payers, Masters isn't suggesting stocks are overpriced generally. In fact, he sees strong potential, with stocks priced slightly below their historic average P/E ratio. Current risks abound, from challenges such as the so-called "fiscal cliff" to Europe's debt crisis. But Masters says companies generally have modest debt and plenty of cash.

He sees the best current opportunity in value stocks, which he defines as stocks that are priced low relative to the book value of the underlying company. That's the value of the assets on a company's balance sheet minus its liabilities. While many value stocks pay dividends, not all do, and Masters sees an abundance of potential bargains in the group.

Stocks in the least expensive 20 percent of the S&P 500 based on price-to-book values are trading at a discounted level that's comparable to the bargain-bin prices when stocks hit bottom in March 2009.

"Cheap stocks are very, very cheap today, relative to any time in long-term history," Masters says. "That makes them very compelling."

But Masters cautions investors not to expect a big short-term gain from moving their money into value stocks. Markets can be so unpredictable in the short term that it's hard to say when such an approach might pay off.